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Jan 2018
The Functions Of The Financial System
• The financial system includes markets and various financial intermediaries that help
transfer financial assets, real assets, and financial risks in various forms from one entity to
another, from one place to another, and from one point in time to another.
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The Functions Of The Financial System Cont’d
• Main Functions of Financial System
a. Helping People Achieve Their Purposes in Using the Financial System:
Saving: The financial system facilitates savings when institutions create investment
vehicles, such as bank deposits, notes, stocks, mutual funds, that investors can acquire
and sell without paying substantial transaction costs.
Borrowing: The financial system facilitates borrowing. Lenders aggregate from savers
the funds that borrowers require. Borrowers must convince lenders that they can repay
their loans, and that, in the event they cannot lenders can recover most of they funds
lent.
Raising Equity Capital: The financial system helps promote capital formation by
producing the financial information needed to determine fair prices for equity.
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The Functions Of The Financial System Cont’d
a. Helping People Achieve Their Purposes in Using the Financial System
Managing Risks: The financial system facilitates risk management when liquid
markets exist in which risk managers can trade instruments that are correlated (or
inversely correlated) with the risks that concern them without incurring substantial
transaction cost.
Exchanging Assets for Immediate Delivery (Spot Market Trading): The financial
system facilitates exchanges when liquid spot markets exist in which people can
arrange and settle trades without substantial transaction cots.
c. Capital Allocation Efficiency: Primary capital markets are the markets in which
companies and government raise capital. Economies are said to be allocationally efficient
when their financial systems allocate capital to those uses that are most productive.
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Assets And Contracts
• Classification of Assets and Markets
a. Securities: People, companies, and government sell securities to raise money. They are
broadly classified as fixed-income, instruments, equities, and shares in pooled
investment policies.
Forward Contracts: A forward contract is an agreement to trade the underlying asset in the future at a
price agreed upon today. Forward contracts are very common, but two problems limit their usefulness
for many market participants. They are counterparty risk and liquidity.
Futures Contracts: A futures contract is a standardized forward contract for which a clearinghouse
guarantees the performance of all traders.
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Assets And Contracts Cont’d
c. Contracts
Swap Contracts: A swap contract is an agreement to exchange payments
of periodic cash flows that depend on future asset prices or interest rates.
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Assets And Contracts Cont’d
d. Commodities: Commodities include precious metals, energy products,
industrial metals, agricultural products, and carbon credits. Spot commodity
markets trade commodities for immediate delivery whereas the forward and
futures markets trade commodities for future delivery.
e. Real Assets: Real assets include such tangible properties as real estate,
airplanes, machinery, or lumber stands. These assets normally are held by
operating companies, such as real estate developers, airplane leasing
companies, manufacturers, or loggers.
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Financial Intermediaries
• Financial intermediaries help entities achieve their financial goals. The services and
products that they provide help connect buyers and sellers in various ways
a. Brokers, Exchanges, and Alternative Trading Systems:
Brokers: They are agents who fill orders fro their clients. They do not trade with their
clients. Instead, they search for traders who are willing to take the other side of their
client’s orders.
Block brokers: They provide brokerage service to large traders. Large orders are hard
to fill because finding a counterparty willing to do a large trade is often quite difficult.
Investment banks: They provide advice to their mostly corporate clients and help
them arrange transactions such as initial and seasoned securities offerings.
Exchanges: They provide places where traders can meet o arrange their trades.
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Financial Intermediaries Cont’d
b. Dealers: Dealers fill clients’ orders by trading with them. They buy instruments for their
own accounts when their clients want to buy securities. The service that dealers provide is
liquidity. Liquidity is the ability to buy or sell with low transaction costs when you want to
trade.
c. Securitizers: Banks and investment companies.
• The process of creating new financial assets by buying assets, placing them in a pool,
and then selling securities that represent ownership of the pool is called securitization.
e. Insurance Companies: Insurance companies help people and companies offset risks that
concern them. They do this by creating insurance contracts (policies) that provide a
payment in the event that some loss occurs.
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Financial Intermediaries Cont’d
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Positions
• A position in an asset is the quantity of the instrument that an entity owns or owes. A
portfolio consists of a set of positions; short and long positions.
a. Short Positions: Short sellers create short positions in contracts by selling contracts that they do not
own. Short sellers create short positions in securities by borrowing securities from security lenders
who are long holders.
b. Levered Positions: Traders usually buy securities by borrowing the money from their brokers. The
borrowed money is called the margin loan, and they are said to buy on margin. Traders who buy
securities on margin are subject to minimum margin requirements.
The initial margin requirement is the minimum fraction of the purchase price that must be
trader’s equity.
The relation between risk and borrowing is called financial leverage.
The leverage ratio is the ratio of the value of the positions to the value of eh equity investment
in it.
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Orders
• Buyers and sellers communicate with the brokers, exchanges, and dealers that arrange their
traders by issuing orders. All orders specify what instrument to trade, how much to trade,
and whether to buy or sell.
a. Execution Instructions: Market and limit orders convey the most common execution
instructions.
A market order instructs the broker or exchange to obtain the best price immediately available
when filling the order. Market orders generally execute immediately if other traders are willing to
take the other side of the trade.
A limit order conveys almost the same instruction. The main problem with limit orders is that they
may not execute. Limit orders do not execute if the limit price on a buy order is too low, or if the
limit price on a sell order is too high. The probability that a limit order will execute depends on
where the order is placed relative to market prices.
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Orders
b. Validity Instructions: Validity instructions indicate when an order may be filled. The
most common validity instruction is day order. A day order is good for the day on which it
is submitted. If it has been filled by the close of business, the order expires unfilled.
Good-till-cancelled orders: most brokers limit how long they will manage an order to
ensure that they do not fil orders, by limiting their GTC orders to a few months.
Immediate or cancel orders: are good only upon receipt by the broker or exchange. If
they cannot be filled in part or in whole, they cancel immediately. In some markets, these
orders are also known as fill or kill orders.
Good-on-close: orders can only be filled at the close of trading. Many traders also use
good-on-open orders.
Stop orders: A stop order is an order in which a trader has specified a stop price
condition. The stop order may not be filled until the stop price condition has been
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Orders
C. Clearing Instructions:
• Clearing instructions tell brokers and exchanges how to arrange final settlement of
trades.
• Traders generally do not attach these instructions to each order, instead they provide
them as standing instructions.
• These instructions indicate what entity is responsible foe clearing and settling trade.
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Orders ….contd.,
• An important clearing instructions that must appear on security sale orders is
an indication of whether the sale is a long sale or a short sale.
For a long sale, the broker must confirm that the securities held are
available for delivery.
For a short sale, the broker must either borrow the security on behalf of
the client or confirm that the client can borrow the security.
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Primary Security Markets
• An issuer makes an initial public offering when it sells the security to the public or the first
time. A seasoned security is a security that an issuer has already issued. If the issuer wants
to sell additional units of a previously issued security, it makes a seasoned (secondary)
offering. Both types of offerings occur in primary markets.
a. Public Offerings: Corporations generally contract with an investment bank to help them
sell their securities to the public.
Book Building: The process in which investment bank lines up subscribers who will buy the
security.
Underwritten offering: The most common type of offering. The investment bank guarantees
the sale of the issue at an offering price that it negotiates with the issuer.
Best efforts offering: The investment bank acts only as a broker. If the offering is
undersubscribed, the issuer will not sell as much as it hoped to sell.
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Primary Security Markets Cont’d
b. Private: Placements and Other Primary Market Transactions: In a private placement,
corporations sell securities directly to a small group of qualified investors, usually with the
assistance of an investment bank.
Corporations sometimes sell new issues of seasoned securities directly to the public
on a piecemeal basis via shelf registration. In a shelf registration, the corporation
makes all pubic disclosures that it would for a regular offering. Shelf registration
offers corporation with flexibility in the timing of their capital transactions.
Corporations may also issue shares via dividend reinvestments plans that allow their
shareholders to reinvest their dividends in newly issued shares of the corporation.
Finally, corporations can issue new stock via rights offering. In a rights offering, the
corporation distributes rights to buy stock at a fixed price to existing shareholders in
proportion to their holdings.
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Primary Security Markets Cont’d
c. Importance of Secondary to Primary Markets:
Corporations and governments can raise money in the primary markets at lower cost
when their securities will trade in liquid secondary markets.
In a liquid market, traders can buy or sell with low transaction costs and small price
concessions when they want to trade.
Investors pay more for securities that they can easily sell than for those that they
cannot easily sell. Higher prices translate into lower costs of capital for the issuers.
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Secondary Security Market and Contract Market
Structures
a. Trading Sessions: In a call market, trades can be arranged only when the market is
called at a particular time and place. In contrast in a continuous market, trade can be
arranged and executed any time the market is open.
b. Execution Mechanism: The three main types of market structures are quote-driven
markets, order-driven markets, and brokered markets.
Quote-driven Markets: Almost all bonds, currencies and most spot commodities trade in quote-driven
markets. Customers trade at the prices quoted by dealers. They are often called over-the-counter
markets.
Order-driven Markets: Order-driven markets arrange trades using rules to match buy orders to sell
orders. Two set of rules characterize order-driven market mechanism: Order matching rules and trade
pricing rules.
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Secondary Security Market and Contract Market
Structures Cont’d
b. Execution Mechanism:
Order-driven Markets
• Order Matching Rules: The first rule is price priority. The highest priced buy orders and the lowest
prices sell orders go first. Secondary precedence rules determine how to rank orders at the same price.
• Trade Pricing Rules: It is used to determine the trade price. The three rules are; the uniform pricing
rule, the discriminatory pricing rule, and the derivative pricing rule.
Brokered Markets: Brokers organize markets for instruments for which finding a buyer
or a seller willing to trade is difficult because the instruments are unique an thus of
interest only to a limited number of people or institutions.
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Secondary Security Market and Contract Market
Structures Cont’d
c. Market Information Systems: Markets vary in the type and quantity of data that they
disseminate to the public. Markets are post trade transparent if the market publishes trade
prices and sizes soon after trades occur.
Dealers prefer to trade in opaque markets because, as frequent traders, they have
an information advantage over those who know less than they do.
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Well-Functioning Financial Systems
• In a well-functioning system:
Investors can easily move money from the present to the future while obtaining a fair rate of
return for the risks that they bear.
Borrowers can easily obtain funds that they need to undertake current projects if they can
credibly promise to repay the funds in the future.
Hedgers can easily trade away or offset the risks that concern them.
Traders can easily trade currencies for their currencies or commodities that they need.
Complete markets: the financial system has a complete market if the assets or contracts
needed to solve these problems are available to trade.
Operationally efficient: the financial system is operationally efficient if the costs of
arranging these trades are low.
Informationally efficient: financial system is informationally efficient if the prices of the
assets and contracts reflect all available information related to fundamental rules.
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Well-Functioning Financial Systems Cont’d
Timely financial disclosures by corporations and governments that allow market participant to estimate
the fundamental values of securities.
Prices that reflect fundamental values so that prices vary primarily in response to changes in fundamental
values and not demands for liquidity made by uninformed traders.
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Market Regulation
• Regulators generally seek to promote fair and orderly markets in which
traders can trade at prices that accurately reflect fundamental values without
incurring excessive transaction costs.
• The objectives of market regulation are to:
Control fraud
Promote fairness
Prevent undercapitalized financial firms from exploiting their investors by making excessively
risky investments.